Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post. The purported reason: Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation. In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional). The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo. This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy. That resulted in runaway inflation and a plunging currency. By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase. The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly. This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.

In an ideal world, portfolio investing is all about comparing the returns available among the three liquid asset classes–stocks, bonds and cash–and choosing the mix that best suits one’s needs and risk preferences.

In the real world, the markets are sometimes gripped instead by almost overwhelming waves of greed or fear that blot out rational thought about potential future returns. Once in a while, these strong emotions presage (where did that word come from?) a significant change in market direction. Most often, however, they’re more like white noise.

In the white noise case, which I think this is an instance of, my experience is that people can sustain a feeling of utter panic for only a short time. Three weeks? …a month? The best way I’ve found to gauge how far along we are in the process of exhausting this emotion is to look at charts (that is, sinking pretty low). What I want to see is previous levels where previously selloffs have ended, where significant new buying has emerged.

I typically use the S&P 500. Because this selloff has, to my mind, been mostly about the NASDAQ, I’ve looked at that, too. Two observations: as I’m writing this late Tuesday morning both indices are right at the level where selling stopped in June; both are about 5% above the February lows.

My conclusion: if this is a “normal” correction, it may have a little further to go, but it’s mostly over. Personally, I own a lot of what has suffered the most damage, so I’m not doing anything. Otherwise, I’d be selling stocks that have held up relatively well and buying interesting names that have been sold off a lot.

What’s the argument for this being a downturn of the second sort–a marker of a substantial change in market direction? As far as the stock market goes, there are two, as I see it:

–Wall Street loves to see accelerating earnings. A yearly pattern of +10%, +12%, +15% is better than +15%, +30%, +15%. That’s despite the fact that the earnings level in the second case will be much higher in year three than in the first.

Why is this? I really don’t know. Maybe it’s that in the first case I can dream that future years will be even better. In the second case, it looks like the stock in question has run into a brick wall that will stop/limit earnings advance.

What’s in question here is how Wall Street will react to the fact that 2018 earnings are receiving a large one-time boost from the reduction in the Federal corporate tax rate. So next year almost every stock’s pattern in will look like case #2.

A human being will presumably look at pre-tax earnings to remove the one-time distortion. But will an algorithm?

–Washington is going deeply into debt to reduce taxes for wealthy individuals and corporations, thereby revving the economy up. It also sounds like it wants the Fed to maintain an emergency room-low level of interest rates, which will intensify the effect. At the same time, it is acting to raise the price of petroleum and industrial metals, as well as everything imported from China–which will slow the economy down (at least for ordinary people). It’s possible that Washington figures that the two impulses will cancel each other out. On the other hand, it’s at least as likely, in my view, that both impulses create inflation fears that trigger a substantial decline in the dollar. The resulting inflation could get 1970s-style ugly.

My sense is that the algorithm worry is too simple to be what’s behind the market decline, the economic worry too complicated. If this is the seasonal selling I believe it to be, time is a factor as well as stock market levels. To get the books to close in an orderly way, accountants would like portfolio managers not to trade next week.

One of Mr. Trump’s first actions as president was to withdraw the US from the Trans-Pacific Partnership, a consortium of world nations seeking, among other things, to halt Chinese theft of intellectual property.

…and metals

Trump has apparently since discovered that this is a serious issue but has decided that the US will go it alone in addressing it. His approach of choice is to place tariffs on goods imported from China–steel and aluminum to start with–on the idea that the harm done to China by the tax will bring that country to the negotiating table. In what seems to me to be his signature non-sequitur-ish move, Mr. Trump has also placed tariffs on imports of these metals from Canada and from the EU.

This action has prompted the imposition of retaliatory tariffs on imports from the US.

the effect of tariffs

–the industry being “protected’ by tariffs usually raises prices

–if it has inferior products, which is often the case, it also tends to slow its pace of innovation (think: US pickup trucks, some of which still use engine technology from the 1940s)

–some producers will leave the market, meaning fewer choices for consumers; certainly there will be fewer affordable choices

–overall economic growth slows. The relatively small number of people in the protected industry benefit substantially, but the aggregate harm, spread out among the general population, outweighs this–usually by a lot

is there a plan?

If so, Mr. Trump has been unable/unwilling to explain it in a coherent way. In a political sense, it seems to me that his focus is on rewarding participants in sunset industries who form the most solid part of his support–and gaining new potential voters through trade protection of new areas.

automobiles next?

Mr. Trump has proposed/threatened to place tariffs on automobile imports into the US. This is a much bigger deal than what he has done to date. How so?

–Yearly new car sales in the US exceed $500 billion in value, for one thing. So tariffs that raise car prices stand to have important and widespread (negative) economic effects.

–For another, automobile manufacturing supply chains are complex: many US-brand vehicles are substantially made outside the US; many foreign-brand vehicles are made mostly domestically.

–In addition, US car makers are all multi-nationals, so they face the risk that any politically-created gains domestically would be offset (or more than offset) by penalties in large growth markets like China. Toyota has already announced that it is putting proposed expansion of its US production, intended for export to China, on hold. It will send cars from Japan instead. [Q: Who is the largest exporter of US-made cars to China? A: BMW –illustrating the potential for unintended effects with automotive tariffs.]

More significant for the long term, the world is in a gradual transition toward electric vehicles. They will likely prove to be especially important in China, the world’s largest car market, which has already prioritized electric vehicles as a way of dealing with its serious air pollution problem.

This is an area where the US is now a world leader. Trade retaliation that would slow domestic development of electric vehicles, or which would prevent export of US-made electric cars to China, could be particularly damaging.

This has already happened once to the US auto industry during the heavily protected 1980s. The enhanced profitability that quotas on imported vehicles created back then induced an atmosphere of complacency. The relative market position of the Big Three deteriorated a lot. During that decade alone, GM lost a quarter of its market share, mostly to foreign brands. Just as bad, the Big Three continued to damage their own brand image by offering a parade of high-cost, low-reliability vehicles. GM has been the poster child for this. It controlled almost half the US car market in 1980; its current market share is about a third of that.

In sum, I think Mr. Trump is playing with fire with his tariff policy. I’m not sure whether he understands just how much long-term damage he may inadvertently do.

stock market implications

One of the quirks of the US stock market is that autos and housing are key industries for the economy but neither has significant representation in the S&P 500–or any other general domestic index, for that matter.

Tariffs applied so far will have little direct negative impact on S&P 500 earnings, although eventually consumer spending will slow a bit. So far, fears about the direction in which Mr. Trump may be taking the country–and the failure of Congress to act as a counterweight–have expressed themselves in two ways. They are:

–currency weakness and

–an emphasis on IT sector in the S&P 500. Within IT, the favorites have been those with the greatest international reach, and those that provide services rather than physical products. My guess is that if auto tariffs are put in place, this trend will intensify. Industrial stocks + specific areas of retaliation will, I think, join the areas to be avoided.

Of course, intended or not (I think “not”), this drag on growth would be coming after a supercharging of domestic growth through an unfunded tax cut. This arguably means that the eventual train wreck being orchestrated by Mr. Trump will be too far down the line to be discounted in stock prices right away.

It’s not clear to me whether Mr. Trump’s macroeconomic policy forms a coherent whole (so far it doesn’t seem to). I’m not sure either whether, or how well, he understands the implications of the steps he’s taking.

The major thrusts:

income taxes

Late last year, the Trump administration passed an income tax bill. It had three main parts:

–reduction in the top corporate tax rate from 35% (highest in the world) to 21% (about average). This should have two beneficial effects: it will stop tax inversions, the process of reincorporating in a foreign low-tax country by cash-rich firms; and it removes the rationale for transferring US-owned intellectual property to the same tax-shelter destinations so that royalties will also be lightly taxed.

–large tax cuts for the wealthiest US earners, continuing the tradition of “trickle down” economics (which posits that this advantage will somehow be transmitted to everyone else)

–failure to eliminate special interest tax breaks, or adopting any other means for offsetting revenue lost to the IRS from the first two items.

Because of this last, the tax bill is projected to add $1 trillion + to the national debt over time. Also, since the reductions aren’t offset by additional taxes elsewhere, the tax cuts represent a substantial net stimulus to the US economy.

This might have been very useful in 2009, when the US was in dire need of stimulus. Today, however, with the economy at full employment and expanding at or above its long-term potential, the extra boost to the economy is potentially a bad thing, It ups the chances of overheating. We need only look back to the terrible experience of runaway inflation the late 1979s to see the danger–something which would require a sharp increase in interest rates to curtail.

interest rates

Arguably, the new income tax regime gives the Fed extra confidence to continue to raise interest rates back up to out-of-intensive-care levels. More than that, the tax cut bill seems to me to demand that the Fed continue to raise rates. Oddly–and worryingly, Mr. Trump has begun to jawbone the Fed not to do so. That’s even though the current Fed Funds rate is still about 100 basis points below neutral, and maybe 150 bp below what would be appropriate for an economy as strong as this. Again this raises the specter of the political climate of the 1970s, when over-easy money policy was used for short-term political advantage …and of the 20%+ interest rates needed in the early 1980s to undo fiscal and monetary policy mistakes.

trade

This is a real head-scratcher.

“national security”

The Constitution gives Congress control over trade, not the executive branch of government. One exception–Congress has delegated its power to the president to act in emergency cases where national security is threatened. Mr. Trump argues (speciously, in my view) that there can be no national security if the economy is weak. Therefore, every trade action is a case of national security. In other words, this emergency power gives the president complete control over all trade matters. What’s odd about this state of affairs is that so far Congress hasn’t complained.

I’m taking off my hat as an American and putting on my hat as an investor for this post.

That is, I’m putting aside questions like whether the Trump agenda forms a coherent whole, whether Mr. Trump understands much/any of what he’s doing, whether Trump is implementing policies whispered in his ear by backers in the shadows–and why congressmen of both parties have been little more than rubber stamps for his proposals.

My main concern is the effect of his economic policies on stocks.

the tax cut

The top corporate tax rate was reduced from 35% to 21% late last year. In addition, the wealthiest individuals received tax breaks, a continuation of the “trickle down” economics that has been the mainstay of Washington tax policy since the 1980s.

The new 21% rate is about average for the rest of the world. This suggests that US corporations will no longer see much advantage in reincorporating abroad in low-tax jurisdictions. The evidence so far is that they are also dismantling the elaborate tax avoidance schemes they have created by holding their intellectual property, and recognizing most of their profits, in foreign low-tax jurisdictions. (An aside: this should have a positive effect on the trade deficit since we are now recognizing the value of American IP as part of the cost of goods made by American companies overseas (think: smartphones.)

My view is that this development was fully discounted in share prices last year.

The original idea was that tax reform would also encompass tax simplification–the elimination of at least part of the rats nest of special interest tax breaks that plagues the federal tax code. It’s conceivable that Mr. Trump could have used his enormous power over the majority Republican Party to achieve this laudable goal. But he seems to have made no effort to do so.

Two important consequences of this last:

–the tax cut is a beg reduction in government income, meaning that it is a strong stimulus to economic activity. That would have been extremely useful, say, nine years ago, but at full employment and above-trend growth, it puts the US at risk of overheating.

–who pays for this? The bill’s proponents claim that the tax cut will pay for itself through higher growth. The more likely outcome as things stand now, I think, is that Millennials will inherit a country with a least a trillion dollars more in sovereign debt than would otherwise be the case.

One positive consequence of the untimely fiscal stimulus is that it makes room for the Fed to remove its monetary stimulus (it now has rates at least 100 basis points lower than they should be) faster, and with greater confidence that will do no harm.

Two complications: Mr. Trump has begun to jawbone the Fed not to do this, apparently thinking a supercharged, unstable economy will be to his advantage. Also, higher rates raise the cost of borrowing to fund a higher government budget deficit + burgeoning government debt.

I started watching the Murdoch family in the mid-1980s, when I was managing a large Australian portfolio. The original business of News Corp, the parent of FOX, was politically-oriented media targeted at right-of-center blue collar workers in Australia. As I saw it, News consistently traded positive news coverage to its right-of-center audience in return for regulatory favors. Rupert Murdoch’s genius was to replicate this model on successively larger stages, first in the UK and then in the US.

Today–again, as I see it–Rupert is moving to turn the family business over to his two sons, on the idea that they will follow in his footsteps as he did his father’s. This desire has two implications for the bidding war between DIS and CMCSA for the FOX media assets:

–the Murdoch family wants equity, not cash. That’s only partly for tax reasons (because taking cash would presumably trigger a big capital gains bill, while taking equity in the successor company wouldn’t). Just as important,

–the next generation of Murdochs wants to continue to have a seat at the media table. The fact that they would own a lot of DIS stock and the fact that there’s no clear successor to the current DIS chairman make it an ideal landing spot. Comcast, in contrast, is another family-controlled company. The last thing Comcast wants is to let in a potentially powerful internal rival. This means CMCSA issuing stock is probably out of the question–and certainly not the favored class of stock the Roberts family uses to maintain control. So Comcast doesn’t suit the Murdochs at all.

Most institutional investors don’t pay taxes, so they’re indifferent to whether they get stock or cash.

I don’t think it’s an accident that the Comcast offer for FOX is at a level that more than compensates any long-term holder of FOX for the tax he would owe on selling. In other words, FOX directors can’t use the grounds that they’re “protecting” shareholders from tax by rejecting the Comcast offer in favor of DIS. After the Supreme Court ruling allowing the ATT/Time Warner merger, they may not be able to argue that a Comcast/Fox merger would run afoul of regulators, either.

At first blush, the Comcast position seems a lot weaker than DIS’s. The Murdochs want to sell to DIS and, I think, actively don’t want to sell to Comcast. As for DIS, it faces a continuing problem finding places to reinvest its huge media cash flows. And opportunities like FOX don’t turn up every day.

What is Comcast’s strategy? My guess is that it’s hoping to raise the offer price to a point where DIS drops out and public pressure forces FOX to sell itself to Comcast. From what I can tell, it would likely need a partner to do so.

I’ve got no desire to participate, but this will be an interesting battle to watch.